September 22, 2015

Timothy D. Hauser

Deputy Assistant Secretary 

Employee Benefits Security Administration

U.S. Department of Labor

200 Constitution Ave, NW, Ste. N-5677

Washington DC 20210

Lyssa Hall

Office of Exemption Determinations 

Employee Benefits Security Administration

U.S. Department of Labor

200 Constitution Ave, NW, Ste. N-5700

Washington, DC 20210

RE: “High-Quality Low-Fee” Exemption Concept

Dear Mr. Hauser and Ms. Hall:

This letter is submitted on behalf of my client Federated Investors, Inc.1in 

response to the Department’s request for public comment on the potential concept 

of a “high-quality low-fee” exemption from the prohibited transaction provisions 

of the Employee Retirement Income Security Act of 1974 (ERISA) and the 

Internal Revenue Code that generally prohibit fiduciaries for retirement investors 

from receiving compensation from third parties. 

The Department invited comment on the possibility of a “high-quality 

low-fee” exemption in conjunction with its proposal to define who is a “fiduciary” 

under ERISA as a result of giving investment advice and a proposed “best 

interest” contract exemption.2 As we understand, the Department wants to know 

whether an exemption from the “best interest” contract exemption practically can 

be devised to allow fiduciary advisers to receive otherwise prohibited 

compensation in connection with investments in “high-quality low-fee”

investments subject to fewer conditions than would apply under the “best interest” 

________________________

1 Federated Investors, Inc. (“Federated”) manages $350 billion in assets through 130 

funds and other investment vehicles to more than 7,900 institutions and intermediaries 

worldwide. Federated’s mutual funds are made available to employee benefit plans and 

individual retirement accounts (IRAs) through institutional intermediaries. 

2 75 Federal Register 21927 and 21960 (April 20, 2015).

F E I N L A W O F F I C E S

(202) 302-3874

melanie@feinlawoffices.com

Admitted in Virginia and

the District of Columbia
Timothy D. Hauser

Lyssa Hall

September 22, 2015

Page 5

contract exemption. The concept reflects the Department’s view that “highquality low-fee” investments “do not present serious potential material conflicts 

of interest” and “present minimal risk of abuse.”

Because the proposed best interest contract exemption would impose 

significant compliance burdens, an exemption with lesser burdens is an appealing 

idea. However, we believe that both the “best interest” contract exemption and a 

“high-quality low-fee” exemption are problematic. Many commenters have 

pointed to operational impracticalities, compliance issues, and other difficulties 

with the “best interest” contract exemption and we will not repeat them here. Our 

purpose is to call your attention to issues we see in the “high-quality low-fee”

concept from a fiduciary law point of view. 

As the Department has recognized and the U.S. Supreme Court has held, 

trust law is the underpinning law of ERISA.3 The bedrock principles of trust

fiduciary law are the duty of loyalty and the duty of prudence. The Department

has indicated that its main concern in issuing its proposals is with conflicts of 

interest, and thus the duty of loyalty. But the Department’s concept of applying

that duty in the context of a “high-quality low-fee” exemption is incompatible 

with the duty of prudence. 

The Department does not distinguish analytically between the duty of 

loyalty and the duty of prudence, which are conceptually distinct. Yet the “highquality low-fee” concept appears to subordinate the goal of prudent investment 

recommendations to the goal of minimizing conflicts of interest. The Department 

devotes little or no attention to the meaning of “high-quality” other than to imply 

that it means “low-fee.” 

In order to better understand the fiduciary law implications of the 

Department’s proposals, Federated Investors, Inc. asked trust law professors 

Robert Sitkoff of Harvard University and Max Schanzenbach of Northwestern 

University to analyze the Department’s proposals, particularly in light of modern 

portfolio principles incorporated in fiduciary law. These professors are the 

leading experts in the field of trust investment law, and their paper is enclosed. 

As you will see, they have concluded that the concept of an exemption for “highquality low-fee” investments is irreconcilable with both controlling fiduciary law 

and well-accepted economics of fiduciary investment. They summarize their 

analysis as follows:

________________________

3 See Tibble v. Edison Int’l, 135 S. Ct. 1823, 1828 (2015).
Timothy D. Hauser

Lyssa Hall

September 22, 2015

Page 5

Americans now hold trillions of dollars in individual 

retirement savings accounts. Concerned about conflicts of interest 

among financial advisers who provide advice to retirement savers, 

the Department of Labor has proposed imposing fiduciary status 

and a “best interest” standard on such advisers. To ameliorate the 

resulting compliance costs, the DOL has also raised the possibility 

of a safe harbor for certain “high-quality low-fee investments.” 

However, the notion of a “high-quality” investment is in 

irreconcilable tension with the highly individualized assessment of 

risk and return that is required by modern portfolio theory, the 

well-accepted concept from financial economics that has been 

codified in the “prudent investor rule” as the standard of care for 

fiduciary investment. This policy incoherence is worrisome 

because of the potential for the safe harbor to swallow the best 

interest standard. 

In order to devise such an exemption, the Department would need to 

define exactly what a “high-quality” investment is. But the Department did not 

even attempt to suggest a definition or request comment on that, focusing instead 

on fees and conflicts of interest rather than the qualitative prudence of an 

investment. The Department seems to equate “high-quality” as synonymous with 

“low-cost,” contrary to principles of modern portfolio theory that inform the duty 

of prudence in modern trust law. As Professors Sitkoff and Schanzenbach discuss, 

those principles require a “highly individualized assessment of risk and return.” 

In addition to the incoherence of a “high-quality” investment, as explained 

by Professors Sitkoff and Schanzenbach, Federated agrees with several practical

concerns the Department identified with a “high-quality low-fee” exemption 

concept. As the Department stated, “there may be no single, objective way to 

evaluate fees and expenses associated with mutual funds (or other investments) 

and no single cut-off to determine when fees are sufficiently low. One cut-off 

could be too low for some investors’ needs and too high for others’.” Federated 

agrees. As the Department recognized, a very low cut-off “would strongly favor 

passively managed funds” and multiple cut-offs for different product categories 

“would be complex and would risk introducing bias between the categories.” 

Federated agrees with the Department that “it is unclear whether mutual funds 

with the lowest fees necessarily represent the highest quality investments for 

Retirement Investors.”

Determining what fees should be included in defining a “low-fee” mutual 

fund is challenging because of the variety of fees mutual funds charge to cover 

their expenses. Fees are paid to investment advisers, custodians, transfer agents, 

administrators, broker-dealers, record keepers, distributors, and accountants. As 
Timothy D. Hauser

Lyssa Hall

September 22, 2015

Page 5

the Department has recognized, a fund may charge purchase fees, redemption 

fees, 12b-1 fees, and other fees. SEC rules require disclosure of such fees in 

mutual fund prospectuses and the Department itself requires standardized fee 

disclosures, making fee comparisons easy for investors. 

Mutual funds offer different classes of shares with different fee 

arrangements to meet different investor preferences. For example, Class C shares 

are structured with revenue sharing or other fees to compensate plan sponsors

who provide recordkeeping and administrative services in connection with 

investments by their employees in the fund. Class C shares can be offered to 

employees without an account-level fee and are frequently are used by retirement 

plan sponsors as a means of encouraging participation in investment plans.

The Department also would need to determine how and when the fee 

calculation should be performed. For example, as the Department queried, what 

time period should the fee calculation cover? Should it include fees projected 

over future time periods (e.g., one, five, and ten year periods) to lower the impact 

of one-time transactions costs such as sales loads? How should the present value 

of future fees be determined?

These questions suggest that the compliance burden of a “high-quality 

low-fee” exemption would fall not only on ERISA fiduciary advisers but on 

mutual funds, and thereby increase the cost of mutual fund investments for 

retirement investors. A “high-quality low-fee” exemption also could interfere 

with market-based mutual fund pricing and share class structures and would seem 

far afield from matters properly within the Department’s sphere under ERISA.

 ****

We appreciated this opportunity to comment on the Department’s 

proposed concept and urge you particularly to read the enclosed analysis of the 

Department’s release prepared by Professors Sitkoff and Schanzenbach. Please 

do not hesitate to contact us if we can provide further information or answer any 

questions you may have.

Sincerely,

 Melanie L. Fein

Melanie L. Fein

Enclosure
ISSN 1936-5349 (print) 

ISSN 1936-5357 (online)

HARVARD

JOHN M. OLIN CENTER FOR LAW, ECONOMICS, AND BUSINESS

FIDUCIARY FINANCIAL ADVISERS AND THE

INCOHERENCE OF A “HIGH-QUALITY LOW-FEE” SAFE HARBOR

Max M. Schanzenbach

Robert H. Sitkoff

Discussion Paper No. 838

09/2015

Harvard Law School

Cambridge, MA 02138

This paper can be downloaded without charge from:

The Harvard John M. Olin Discussion Paper Series:

http://www.law.harvard.edu/programs/olin_center/

The Social Science Research Network Electronic Paper Collection:

http://ssrn.com/abstract=2661833
September 16, 2016

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Fiduciary Financial Advisers and the 

Incoherence of a “High-Quality Low-Fee” Safe Harbor 

Max M. Schanzenbach†

Robert H. Sitkoff††

Abstract

Americans now hold trillions of dollars in individual retirement savings 

accounts. Concerned about conflicts of interest among financial advisers who 

provide advice to retirement savers, the Department of Labor has proposed 

imposing fiduciary status and a “best interest” standard on such advisers. To 

ameliorate the resulting compliance costs, the DOL has also raised the possibility 

of a safe harbor for certain “high-quality low-fee investments.” However, the 

notion of a “high-quality” investment is in irreconcilable tension with the highly 

individualized assessment of risk and return that is required by modern portfolio 

theory, the well-accepted concept from financial economics that has been 

codified in the “prudent investor rule” as the standard of care for fiduciary 

investment. This policy incoherence is worrisome because of the potential for the 

safe harbor to swallow the best interest standard. 

 † Seigle Family Professor of Law, Northwestern University, m-schanzenbach@law.northwestern.edu. 

†† John L. Gray Professor of Law, Harvard University, rsitkoff@law.harvard.edu. 

The authors thank John Langbein for helpful comments and suggestions and Samantha Thompson for 

research assistance. Federated Investors, Inc., provided financial support for this essay and compensated its 

authors for its preparation. In accordance with Harvard Law School policy on conflicts of interest, Sitkoff 

discloses certain outside activities, one or more of which may relate to the subject matter of this essay, at 

https://helios.law.harvard.edu/Public/Faculty/ConflictOfInterestReport.aspx?id=10813.
September 16, 2016

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Introduction

Today the bulk of retirement saving by American workers, worth trillions of 

dollars, is in self-directed individual retirement accounts (IRAs) and defined 

contribution pension plans. Understandably, many workers with self-directed accounts

turn to financial advisers for help in navigating the vast and complicated array of 

investment options in today’s financial markets. Some of these advisers are 

compensated by commissions or service fees from the providers of products the adviser 

sells, raising conflict of interest concerns.

To protect the integrity of financial advice to retirement savers, the Department 

of Labor (DOL) has proposed a new regulation that would impose “fiduciary” status on 

any person who provides “investment advice or recommendations” to an IRA owner or 

to a retirement plan beneficiary.1 Under the proposal, financial advisers to retirement 

savers, including IRA holders, would be subject to “trust law standards of care [i.e., 

prudence] and undivided loyalty.”2 The aim of the proposal is to ensure that all 

retirement savers receive advice that is in the best interest of the saver, that is, advice 

that is both competent and unaffected by a conflict of interest. 

The centerpiece of the DOL proposal is a “Best Interest Contract” exemption that

in implementation of the duty of loyalty would regulate conflicted compensation 

arrangements.3 Under this exemption, an adviser could receive conflicted compensation 

if the adviser’s recommendations were nonetheless in the “best interest” of the client (a 

substantive safeguard) and if the adviser adopted protocols to mitigate conflicts of 

interest (a process safeguard). As regards the duty of care or prudence, the DOL’s 

expectation is that the “best interest” standard would “be interpreted in light of forty 

years of judicial experience with ERISA’s fiduciary standards and hundreds more with 

the duties imposed on trustees under the common law of trusts.”4

In light of the potential compliance costs from the “best interest” fiduciary 

standard, the DOL has also raised the possibility of a safe harbor for certain “highquality low-fee investments.”5 As framed by the materials released by the DOL thus far, 

any investment falling within the “high-quality low-fee” safe harbor would be per se 

permissible. In effect, an investment deemed “high quality” and “low cost” would be 

conclusively presumed to be in the “best interest” of the retirement saver. The 

assumption underlying the safe harbor is “that certain high-quality investments are 

provided pursuant to fee structures in which the payments are sufficiently low that they 

do not present serious potential material conflicts of interest.”6

 1 Definition of the Term “Fiduciary”; Conflict of Interest Rule—Retirement Investment Advice, 80 Fed. 

Reg. 21928 (proposed Apr. 20, 2015) (to be codified at 29 C.F.R. pts. 2509–2510).

2 Id. at 21928.

3 See Proposed Best Interest Contract Exemption, 80 Fed. Reg. 21960 (proposed Apr. 20, 2015) (to be 

codified at 29 C.F.R. pt. 2550).

4 Id. at 21970.

5 Definition of the Term “Fiduciary,” 80 Fed. Reg. at 21929.

6 Proposed Best Interest Contract Exemption, 80 Fed. Reg. at 21978.
September 16, 2016

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The rationale for the safe harbor focuses almost exclusively on the problem of 

conflicts of interest, that is, the fiduciary duty of loyalty. But fiduciary status also 

includes a duty of care or prudence. And the DOL’s analysis does not address whether a 

“high-quality low-fee” safe harbor is sensible with respect to portfolio construction

under the fiduciary duty of prudence. In fact, the notion of a “high-quality” investment 

is in irreconcilable tension with the highly individualized assessment of risk and return 

that is required by modern portfolio theory and the “prudent investor rule” of fiduciary 

investment law. Given the uncertainty, litigation risk, and compliance costs of the best 

interest standard, there is good reason rooted in theory and prior empirical study to 

suppose that many advisers will opt for the safe harbor. It is critical, therefore, that the 

safe harbor be consistent with the controlling law and well-accepted economics of 

fiduciary investment.

The basic idea of modern portfolio theory is that an investor should undertake to 

maximize return and minimize risk, matching the risk and expected return of her overall 

investment portfolio to her particular circumstances. Accordingly, the prudent investor 

rule requires a fiduciary to evaluate the investor’s risk tolerance and investment goals, 

choose a level of overall portfolio market risk and expected return that is commensurate 

with that risk tolerance and goals, and avoid wasteful diversifiable risk. The multiplicity 

of relevant considerations—including the investor’s risk preferences, age and health, 

family status and obligations, and other asset holdings and sources of support—

necessarily requires an investor-specific analysis that cannot be captured in a safe 

harbor. What is a “high-quality” investment for one investor may entail too much risk 

for another. And indeed, what is a “high-quality” investment for a given investor today 

will change as the investor’s circumstances change. In the words of the U.S. Supreme 

Court, “a trustee has a continuing duty to monitor trust investments and remove 

imprudent ones. This continuing duty exists separate and apart from the trustee’s duty 

to exercise prudence in selecting investments at the outset.”7

There is much to commend in the DOL’s effort to bring fiduciary investment 

principles to retirement saving. But the DOL’s suggestion of a safe harbor for “highquality low-fee” investments is misguided. Apart from the risk that the safe harbor will 

in effect displace the rule, a safe harbor for “high quality” investments is in 

irreconcilable tension with the law and economics of fiduciary investment. A core 

principle in both the controlling law and the well-accepted economics of fiduciary 

investment is that no type or kind of investment can be deemed categorically “highquality” for all investors at all times.

Individual Responsibility for Managing Retirement Savings

Over the past four decades, the bulk of retirement saving by American workers, 

measuring in the trillions of dollars, has shifted from defined benefit plans to defined 

contribution plans and individual retirement accounts (IRAs).8 In consequence, much of 

 7 Tibble v. Edison Int’l, 135 S. Ct. 1823, 1828 (2015).

8 See, e.g., Council of Econ. Advisers, The Effects of Conflicted Investment Advice on Retirement 

Savings 5 (Feb. 2015), https://www.whitehouse.gov/sites/default/files/docs/cea_coi_report_final.pdf
September 16, 2016

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the responsibility for investment management of retirement savings has shifted from 

professional fiduciary managers of defined benefit plans to individual savers. In the case 

of a defined contribution plan, the saver chooses from a menu of investment options 

provided by the plan sponsor. Although the sponsor has a fiduciary obligation in the 

creation and ongoing monitoring of the menu,9 the saver is on her own in allocating her 

account among the offered options. In the case of an IRA, almost all investment 

decisions are at the discretion of the saver. Rollovers from a defined contribution plan 

into an IRA are common.

The shift toward greater individual responsibility for investment management of 

retirement savings coincided with a proliferation of investment options. The variety of 

mutual funds available to investors has expanded substantially, for example, and now 

includes a large number of index and exchange-traded funds.10 Devising a portfolio 

from this vast array of investment options that matches one’s retirement goals and 

tolerance for risk is a challenge for even sophisticated investors. There is a growing body 

of evidence, moreover, that retail investors are not generally sophisticated. Many 

individual investors not only lack knowledge about finance but also face cognitive limits 

and behavioral quirks. When presented with a menu of mutual funds, for example, 

many retirement savers divide their investments equally across each of the offered

funds, which is a kind of naïve diversification that is highly unlikely to achieve a 

portfolio appropriate to the saver’s circumstances.11

Toward Fiduciary Financial Advisers

To cope with the bewildering array of investment alternatives, many retirement 

savers look to financial advisers for help in the management of their retirement savings.

“Selecting and managing IRA investments can be a challenging and time-consuming 

task, frequently one of the most complex financial decisions in a person’s life, and many 

Americans turn to professional advisers for assistance.”12 Expert advice is key to 

choosing a diversified portfolio with an appropriate balance of risk and return given the 

retirement goals of the saver. But the benefit of financial advice will be attenuated or 

even lost if the advice is incompetent (i.e., imprudent) or is tainted by a conflict of 

interest (i.e., disloyal).13

 

[hereinafter CEA Report] (“In 1978, traditional pensions accounted for nearly 70 percent of all retirement 

assets. Defined contribution plans accounted for less than 20 percent and IRAs accounted for only 2 percent. 

Annuities accounted for the remainder. By the end of 2013, traditional pensions accounted for only 35 

percent of retirement assets, a decrease of 32 percentage points; defined contribution plans and IRAs 

accounted for more than half of all retirement assets.”).

9 See Tibble, 135 S. Ct. at 1828–29.

10 See Investment Company Institute, 2015 Investment Company Fact Book (55th ed.), 

https://www.ici.org/pdf/2015_factbook.pdf.

11 See Shlomo Benartzi & Richard H. Thaler, Naïve Diversification Strategies in Defined Contribution 

Saving Plans, 91 Am. Econ. Rev. 79 (2001); Ning Tang et al., The Efficiency of Sponsor and Participant 

Portfolio Choices in 401(k) Plans, 94 J. Pub. Econ. 1073 (2010).

12 CEA Report, supra note 8, at 2.

13 Formally this is a principal-agent or agency problem, with the divergence of interests between the 

adviser and the client giving rise to agency costs. See, e.g., Robert H. Sitkoff, An Economic Theory of 
September 16, 2016

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When one person reposes “trust and confidence” in another person at the other 

person’s invitation and in reasonable reliance on the other person’s expertise, the law 

commonly deems the other person a fiduciary subject to duties of loyalty and prudence 

(or care).14 Application of this principle to a financial adviser to a retirement saver is 

unsettled, however, owing to an inconsistent patchwork of state and federal law. The 

extent to which (if at all) the law currently imposes fiduciary status on a financial 

adviser to a retirement saver depends on whether under federal law the adviser is a 

registered financial adviser, a broker-dealer, or otherwise,15 and whether under state law 

the adviser is an agent of the client or otherwise has had special trust and confidence 

reposed in him.16

Against this backdrop of patchwork regulation of financial advisers to retirement 

savers, in April of 2015 the Department of Labor (DOL) proposed a sweeping new 

definition of “fiduciary” status under the Employee Retirement Income Security Act 

(ERISA) and the Internal Revenue Code (the tax code).17 In the words of the DOL: “The 

absence of adequate fiduciary protections and safeguards is especially problematic in 

light of the growth of participant-directed plans and self-directed IRAs; the gap in 

expertise and information between advisers and the customers who depend upon them 

for guidance; and the advisers’ significant conflicts of interest.”18

Under the DOL proposal, a person who provides “investment advice or 

recommendations” to an IRA owner or to a pension plan beneficiary would be deemed a 

fiduciary.19 Under the proposal, therefore, financial advisers to retirement savers, 

 

Fiduciary Law, in Philosophical Foundations of Fiduciary Law (Andrew S. Gold & Paul B. Miller, eds., 

2014); Robert H. Sitkoff, The Economic Structure of Fiduciary Law, 91 B.U. L. Rev. 1039 (2011).

14 See, e.g., Wiener v. Lazard Freres & Co., 672 N.Y.S.2d 8, 14 (App. Div. 1998) (noting that fiduciary 

obligation may arise if “a party reposed confidence in another and reasonably relied on the other’s superior 

expertise or knowledge”); Restatement (Third) of Agency § 8.01 cmt. c (Am. Law Inst. 2006) (noting 

imposition of fiduciary obligation “on the basis that one party to the relationship has in fact reposed trust 

and confidence in the other and has done so consistently with the other’s invitation”); see also Robert H. 

Sitkoff, The Fiduciary Obligations of Financial Advisers Under the Law of Agency, J. Fin. Plan., Feb. 2014, at 

42. 

15 See, e.g., Arthur B. Laby, Reforming the Regulation of Broker-Dealers and Investment Advisers, 65 

Bus. Law. 395 (2010).

16 In Burdett v. Miller, 957 F.2d 1375 (7th Cir. 1992), for example, the court noted that “the relation 

between an investment advisor and the people he advises is not” a per se fiduciary category. Id. at 1381. But

the court imposed fiduciary duties on the defendant investment adviser nonetheless. The plaintiff had 

“reposed trust and confidence” in the defendant, who had held himself out “to be expert as well as 

trustworthy.” Id. The defendant had gained “influence and superiority over” the plaintiff by virtue of his 

claimed “expert knowledge the deployment of which the [plaintiff could not] monitor.” Id.

17 See Definition of the Term “Fiduciary”; Conflict of Interest Rule—Retirement Investment Advice, 80 

Fed. Reg. 21928 (proposed Apr. 20, 2015) (to be codified at 29 C.F.R. pts. 2509–2510).

18 Id. at 21935.

19 Id. at 21928. “Under the [proposal], a person renders investment advice by (1) providing investment 

or investment management recommendations or appraisals to an employee benefit plan, a plan fiduciary, 

participant or beneficiary, or an IRA owner or fiduciary, and (2) either (a) acknowledging the fiduciary 

nature of the advice, or (b) acting pursuant to an agreement, arrangement, or understanding with the advice 

recipient that the advice is individualized to, or specifically directed to, the recipient for consideration in 

making investment or management decisions regarding plan assets.” Id. at 21929.
September 16, 2016

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including IRA holders, would be subject to “trust law standards of care [i.e., prudence]

and undivided loyalty.”20 The trust law duty of care or prudence imposes an objective 

standard of care.21 The trust law duty of undivided loyalty prohibits conflicts of 

interests.22

Conflicts of Interest and Fiduciary Status

The DOL’s analysis of the proposal focuses almost exclusively on the problem of

advisers’ financial conflicts of interest:

Today, individual retirement investors have much greater responsibility for 

directing their own investments, but they seldom have the training or specialized 

expertise necessary to prudently manage retirement assets on their own. As a 

result, they often depend on investment advice for guidance on how to manage 

their savings to achieve a secure retirement. In the current marketplace for 

retirement investment advice, however, advisers commonly have direct and 

substantial conflicts of interest, which encourage investment recommendations 

that generate higher fees for the advisers at the expense of their customers and 

often result in lower returns for customers even before fees.23

In imposing a fiduciary standard on all advisers to retirement savers, the DOL aims to 

ensure that all retirement savers receive competent advice that is in the best interest of 

the saver without bias from the adviser’s personal benefit.24

A fiduciary who receives compensation from an entity whose investment 

products the fiduciary recommends presumptively breaches the duty of loyalty. But 

conflicted advice is not always against the interests of the client. For example, the fact 

that a mutual fund pays 12b-1 fees should not, by itself, exclude that fund as a 

permissible investment for retirement savers, as the DOL’s proposal recognizes.25

Indeed, the common law of trusts tolerates authorized conflicts of interests, provided 

that the trustee acts fairly and in good faith in pursuit of the beneficiary’s best interest.26

That is, trust law regulates authorized conflicts of interest rather than categorically 

prohibiting them. For example, the Uniform Trust Code provides that an investment in a 

mutual fund that pays the trustee fees for services is not presumptively a breach of the 

 20 Id. at 21928.

21 See Restatement (Third) of Trusts § 77 (Am. Law Inst. 2007).

22 See id. § 78.

23 Definition of the Term “Fiduciary,” 80 Fed. Reg. at 21930.

24 See id. at 21933 (“Even when plan sponsors, participants, beneficiaries, and IRA owners clearly rely 

on paid advisers for impartial guidance, the regulation allows many advisers to avoid fiduciary status and 

disregard ERISA’s fiduciary obligations of care and prohibitions on disloyal and conflicted transactions. As 

a consequence, these advisers can steer customers to investments based on their own self-interest (e.g., 

products that generate higher fees for the adviser even if there are identical lower-fee products available), 

give imprudent advice, and engage in transactions that would otherwise not be permitted by ERISA and the 

Code without fear of accountability under either ERISA or the Code.”).

25 See Proposed Best Interest Contract Exemption, 80 Fed. Reg. at 21961.

26 See Restatement (Third) of Trusts § 78 cmt. c(2); Jesse Dukeminier & Robert H. Sitkoff, Wills, Trusts, 

and Estates 591, 593 (9th ed. 2013). 
September 16, 2016

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duty of loyalty.27 More generally, in an authorized conflict-of-interest situation, the 

trustee may act, but “the conduct of the trustee ... will be subject to especially careful 

scrutiny.”28 

The “Best Interest Contract” Exemption:

Regulation Instead of Prohibition

In recognition of the over-inclusiveness of an absolute prohibition on conflicted 

compensation for advisers to retirement savers, the DOL has proposed several new

prohibited transaction exemptions (PTEs) and revisions to existing PTEs that, taken 

together, are meant to regulate conflicted compensation arrangements rather than 

prohibit them categorically. The centerpiece is the “Best Interest Contract” exemption.29

Under this exemption, a conflicted compensation arrangement would be permissible if

the underlying investment is in the “best interest” of the client (a substantive safeguard) 

and if the adviser adopted protocols to mitigate conflicts of interest (a process 

safeguard).30 To qualify, an adviser must

contractually acknowledge fiduciary status, commit to adhere to basic standards 

of impartial conduct, warrant that they have adopted policies and procedures 

reasonably designed to mitigate any harmful impact of conflicts of interest, and 

disclose basic information on their conflicts of interest and on the cost of their 

advice. The adviser and firm must commit to fundamental obligations of fair 

dealing and fiduciary conduct—to give advice that is in the customer’s best 

interest; avoid misleading statements; receive no more than reasonable 

compensation; and comply with applicable federal and state laws governing 

advice.31

 27 Uniform Trust Code § 802(f) (amended 2004) provides as follows:

An investment by a trustee in securities of an investment company or investment 

trust to which the trustee, or its affiliate, provides services in a capacity other than as 

trustee is not presumed to be affected by a conflict between personal and fiduciary 

interests if the investment otherwise complies with the prudent investor rule of [Article] 9. 

In addition to its compensation for acting as trustee, the trustee may be compensated by 

the investment company or investment trust for providing those services out of fees 

charged to the trust. If the trustee receives compensation from the investment company or 

investment trust for providing investment advisory or investment management services, 

the trustee must at least annually notify the persons entitled under Section 813 to receive a 

copy of the trustee’s annual report of the rate and method by which that compensation 

was determined.

28 Restatement (Third) of Trusts § 37 cmt. f(1); see also Dukeminier & Sitkoff, supra note 26, at 593.

29 See Proposed Best Interest Contract Exemption, 80 Fed. Reg. 21960 (proposed Apr. 20, 2015) (to be 

codified at 29 C.F.R. pt. 2550). Another important exception is for principal trades, see Proposed Class 

Exemption for Principal Transactions in Certain Debt Securities Between Investment Advice Fiduciaries and 

Employee Benefit Plans and IRAs, 80 Fed. Reg. 21989 (proposed Apr. 20, 2015) (to be codified at 29 C.F.R. pt. 

2550), which are common for government agency, municipal, and corporate debt; preferred securities; U.S. 

Treasuries; and brokered certificates of deposit.

30 Definition of the Term “Fiduciary,” 80 Fed. Reg. at 21929–21930.

31 Proposed Best Interest Contract Exemption, 80 Fed. Reg. at 21961 (emphasis added).
September 16, 2016

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Notice the italicized reference to the customer’s “best interest.” The Best Interest 

Contract exemption is different in structure from previous PTEs in that it is principlesbased rather than prescriptive.32 The proposal defines best interest as follows:

Best interest is defined to mean that the Adviser and Financial Institution act 

with the care, skill, prudence, and diligence under the circumstances then 

prevailing that a prudent person would exercise based on the investment 

objectives, risk tolerance, financial circumstances, and the needs of the 

Retirement Investor, when providing investment advice to them. Further, under 

the best interest standard, the Adviser and Financial Institution must act without 

regard to the financial or other interests of the Adviser, Financial Institution or 

their Affiliates or any other party. Under this standard, the Adviser and Financial 

Institution must put the interests of the Retirement Investor ahead of the 

financial interests of the Adviser, Financial Institution or their Affiliate, Related 

Entities or any other party.33

The proposal is express in linking this definition of “best interest” to 

“longstanding concepts derived from ERISA and the law of trusts.”34 The DOL’s 

expectation, also stated expressly, is that the best interest standard will “be interpreted 

in light of forty years of judicial experience with ERISA’s fiduciary standards and

hundreds more with the duties imposed on trustees under the common law of trusts.”35

Because the DOL proposal aligns with existing trust and ERISA fiduciary law, 

likely its most significant practical effect will be on financial advisers to IRA holders, as 

they had not previously been subject to similar obligations.36

New Compliance Burdens in the IRA Market

Under the DOL’s two-step imposition of fiduciary status with a “best interest” 

standard, a financial adviser who recommended to an IRA account holder an investment 

product that compensated the adviser but was not in the client’s best interest would be

in breach of duty and subject to liability to the client. In each case, the question 

 32 See id. (“Rather than create a set of highly prescriptive transaction-specific exemptions, which has 

generally been the regulatory approach to date, the proposed exemption would flexibly accommodate a 

wide range of current business practices, while minimizing the harmful impact of conflicts of interest on the 

quality of advice. The Department has sought to preserve beneficial business models by taking a standardsbased approach that will broadly permit firms to continue to rely on common fee practices, as long as they 

are willing to adhere to basic standards aimed at ensuring that their advice is in the best interest of their 

customers.”).

33 Id. at 21970.

34 Id.

35 Id.

36 See Definition of the Term “Fiduciary,” 80 Fed. Reg. at 21938 (“Advisers to ERISA-covered plans are 

already required to adhere to the fundamental standards of prudence and loyalty, and can be held 

accountable for violations of the standards. Rather, the primary impact of the “best interest” standard is on 

the IRA market. ... Incorporating the best interest standard in the proposed Best Interest Contract 

Exemption effectively requires advisers to comply with these basic fiduciary standards as a condition of 

engaging in transactions that would otherwise be prohibited because of the conflicts of interest they 

create.”).
September 16, 2016

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presented would be whether the given advice was in the best interest of the client. The 

purpose would be to deter disloyal and imprudent advice by the threat of after-the-fact 

liability.

The cost of the proposal, however, is an expanded compliance burden and 

increased litigation risk, which is the rationale for a safe harbor, as we discuss below. A 

particular worry raised by the DOL is that the additional compliance burden might push 

some advisers to discontinue advising clients with smaller account balances.37 To qualify 

for the Best Interest Contract exemption, an adviser must adopt conflict-mitigating 

internal “policies and procedures.”38 Moreover, following the trust law tradition, the 

DOL anticipates that review of a fiduciary adviser’s recommendation to an IRA account 

holder will “focus on the process the fiduciary used to reach its determination or 

recommendation.”39 These additional safeguards will raise the cost of providing advice 

to an IRA account holder.

Another source of increased costs will be increased liability exposure and greater 

overall litigation risk. Relative to a prescriptive approach, a principles-based governance 

regime is more uncertain, which will invite defensive and precautionary practices. And

the proposal preserves private rights of action and class actions. Even if an individual 

client’s damages are small, aggregated in a class action those damages can add up to 

substantial liability exposure from even small decisions. In a low-margin business 

dependent on volume, the chilling effect could be a significant.

All told, imposing fiduciary status on financial advisers to IRA account holders 

may well increase the price of that advice, and a higher price would likely cause some 

retirement savers to forgo professional financial advice. It is unclear whether providing 

less conflicted advice to fewer retirement savers would result in a net social welfare gain.

A Safe Harbor for “High-Quality Low-Fee” Investments?

In recognition of the increased compliance burden arising from the imposition of 

fiduciary status with a “best interest” standard, the DOL has also raised the possibility 

of issuing “a separate streamlined exemption that would allow advisers to receive 

otherwise prohibited compensation in connection with plan, participant and beneficiary 

accounts, and IRA investments in certain high-quality low-fee investments, subject to 

fewer conditions.”40 The aim of this streamlined “high-quality low-fee” exemption 

would be to “minimiz[e] compliance burdens for advisers and financial institutions 

when they offer investment products with little potential for material conflicts of 

interest.”41

 37 See, e.g., Proposed Best Interest Contract Exemption, 80 Fed. Reg. at 21979.

38 Id. at 21970.

39 Id.

40 Definition of the Term “Fiduciary,” 80 Fed. Reg. at 21929.

41 Id. at 21948.
September 16, 2016

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Although the DOL has not proposed text for the “high-quality low-fee” 

exemption, owing to “difficulty in operationalizing [the] concept,”42 the DOL has 

clarified that “the streamlined exemption would not expressly contain a ‘best interest’ 

standard.”43 Conceptually, therefore, the “high-quality low-fee” exemption would be a 

safe harbor. “The aim would be to design conditions with sufficient objectivity that 

Advisers and Financial Institutions could proceed with certainty in their business 

operations when recommending the investments.”44

The critical assumption by the DOL is “that certain high-quality investments are 

provided pursuant to fee structures in which the payments are sufficiently low that they 

do not present serious potential material conflicts of interest.”45 On this assumption, the 

DOL reasoned that “a streamlined exemption for high-quality low-fee investments 

could be subject to relatively few conditions, because the investments present minimal 

risk of abuse to plans, participants and beneficiaries, and IRA owners.”46

The DOL’s rationale for the safe harbor focuses almost exclusively on the 

problem of conflicts of interest, that is, the duty of loyalty. The analysis does not address 

whether the exemption is sensible with respect to portfolio construction, that is, the duty 

of prudence. And as we shall see, a safe harbor for “high quality” investments is in 

irreconcilable tension with the highly individualized assessment of risk and return that 

is required by modern portfolio theory as codified by prevailing fiduciary investment 

law, including under ERISA and the law of trusts.

Would the Prescriptive Safe Harbor 

Swallow the Principles-Based Rule?

Before considering the conflict between portfolio theory and a “high-quality” 

safe harbor, it is worth pausing to consider the question posed by the DOL of whether

“the availability of the streamlined exemption [would] discourage Advisers and 

Financial Institutions from offering other types of investments, including higher-cost 

mutual funds, even if the offering of such other investments would be in the best interest 

of the plan, participant or beneficiary, or IRA owner.”47 There is good reason, rooted in 

both economic theory and in empirical study, to believe that the answer is yes.

As a matter of theory, a danger with any prescriptive safe harbor is that in 

practice it will displace the broader principles-based rule from which the safe harbor is 

derived. In particular, if the litigation risk of the principles-based rule is uncertain and 

potentially substantial, and if compensation is constrained (by rule, competition, or 

both), then a safe harbor that avoids the weakly compensated added litigation risk of the 

 42 Id.

43 Proposed Best Interest Contract Exemption, 80 Fed. Reg. at 21978.

44 Id.

45 Id.

46 Id.

47 Id. at 21979.
September 16, 2016

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principles-based rule will be highly attractive.48 For the reasons already canvassed, these 

circumstances appear to be present in the context of the DOL’s fiduciary status proposal.

Others have offered similar analyses in other fiduciary investment contexts.49

As a matter of empirical study, we have shown that in donative trusts the old 

“prudent man rule” of fiduciary investment, which in effect offered a safe harbor for 

government bonds, suppressed investment by bank and other institutional trustees in 

equity.50 Upon repeal of the prudent man rule (that is, upon abrogation of the safe 

harbor), and its replacement with the new “prudent investor rule” rooted in modern 

portfolio theory, there was a statistically and economically significant shift from 

government bonds to equity.51 The safe harbor had skewed investment by professional 

bank and other institutional trustees, in particular in larger trusts for which risk 

tolerance would tend to be greater,52 even though the prudent man rule was nominally a 

default rule and trust instruments typically included boilerplate specifically authorizing

investment in stocks.53 The safe harbor for government bonds avoided the weakly 

compensated additional litigation risk of stock investment, but exposed investors to 

inflation risk and deprived them of the higher expected returns associated with a higher 

risk portfolio.54

The Incoherence in Law and in Economics 

of a Safe Harbor for “High-Quality” Investments55

As we have seen, the basis for the “high-quality low-fee” safe harbor is the 

assumption “that certain high-quality investments are provided pursuant to fee 

structures in which the payments are sufficiently low that they do not present serious 

potential material conflicts of interest.”56 In other words, the personal benefit to an 

adviser from recommending a low-fee investment will be too small to induce the adviser 

to recommend investments that are not in the best interest of the client. The focus of the 

safe harbor, therefore, is on conflicts of interest, that is, the duty of loyalty.

 48 See Max M. Schanzenbach & Robert H. Sitkoff, Did Reform of Prudent Trust Investment Laws Change 

Trust Portfolio Allocation?, 50 J. L. & Econ. 681 (2007).

49 Some have argued that ERISA fiduciaries have invested cautiously in part because the large size of 

ERISA funds gives rise to significant liability exposure. See Diane Del Guercio, The Distorting Effect of the 

Prudent-Man Laws on Institutional Equity Investments, 40 J. Fin. Econ. 31 (1996); Bevis Longstreth, Modern 

Trust Investment Management and the Prudent Man Rule 232–66 (1986).

50 Schanzenbach & Sitkoff, supra note 48, at 707.

51 Id. at 698; Max M. Schanzenbach & Robert H. Sitkoff, The Prudent Investor Rule and Market Risk: An 

Empirical Analysis 8 (Harvard John M. Olin Ctr. for Law, Econ., & Bus., Paper No. 816, 2015), 

http://www.law.harvard.edu/programs/olin_center/papers/pdf/Sitkoff_816.pdf.

52 Schanzenbach & Sitkoff, supra note 51, at 17.

53 Schanzenbach & Sitkoff, supra note 48, at 685; Schanzenbach & Sitkoff, supra note 51, at 7.

54 Schanzenbach & Sitkoff, supra note 48, at 687–88. 

55 Portions of the ensuing analysis are derived without further citation from Schanzenbach & Sitkoff, 

supra note 51.

56 Proposed Best Interest Contract Exemption, 80 Fed. Reg. at 21978.
September 16, 2016

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But fiduciary status triggers also a duty of care or prudence in addition to a duty 

of loyalty. As the DOL has explained, fiduciary status under ERISA and the tax code for 

financial advisers to retirement savers would subject those advisers to “trust law 

standards of care [i.e., prudence] and undivided loyalty.”57 For this reason, the DOL has 

stated that to qualify for the safe harbor an investment must be both “high quality” and

“low fee.” Taking notice of the “prevailing ... view in the academic literature that”

endorses a strategy of “buy[ing] and hold[ing] a diversified portfolio of assets calibrated 

to track the overall performance of financial markets,”58 the DOL has suggested that 

“mutual funds with low all-in fees” would be most apt for inclusion within the “highquality low-fee” safe harbor.59

The error in this analysis is lack of context. As we shall see, the bedrock concept

in both the law and the economics of fiduciary investment is modern portfolio theory.

Yet the term “modern portfolio theory” does not appear even once across the hundreds 

of pages of analysis accompanying the DOL’s fiduciary proposal. The academic 

literature to which the DOL adverts focuses on the merits of active versus passive 

investment strategies. That literature does not suggest that the optimal balance of risk 

and expected return is the same for every investor, and that this universally optimal risk 

and expected return tradeoff points to a fund that tracks the overall market. To the 

contrary, there is broad consensus that the antecedent question of asset allocation within 

portfolio construction should be guided by modern portfolio theory.60

The basic idea, operationalized by the “prudent investor rule” under ERISA and 

trust law, is that an investor should undertake to maximize return and minimize risk, 

matching the risk and expected return of her overall investment portfolio to her 

particular circumstances. For some investors, such as an older person with limited 

resources and immediate cash needs, a substantial investment in a fund that tracks the 

overall market might incur too much risk. For other investors, such as a younger person 

with strong job security and substantial savings, an investment with a higher risk and 

expected return tradeoff might be warranted. 

In the ensuing analysis of the proposed “high-quality low-fee” safe harbor, we 

first review the basics of modern portfolio theory, the core concept from financial 

economics upon which the modern law of fiduciary investment is based. Second, we 

canvass the law of fiduciary investment, both under ERISA and under trust law, taking 

notice in particular of how the prudent investor rule codifies the basic elements of

 57 Definition of the Term “Fiduciary,” 80 Fed. Reg. at 21928.

58 Proposed Best Interest Contract Exemption, 80 Fed. Reg. at 21978.

59 Id.

60 Although the DOL proposal does not address modern portfolio theory or prevailing fiduciary 

investment law, there is a brief suggestion in the proposal that “the streamlined exemption could require 

that the investment product be ‘broadly diversified to minimize risk for targeted return,’ or ‘calibrated to 

provide a balance of risk and return appropriate to the investor’s circumstances and preferences for the 

duration of the recommended holding period.’” Id. However, as noted by the DOL, adding such a condition 

would tend to undermine the nature of the exemption as a safe harbor, reducing its utility in minimizing 

compliance costs. See id. (noting that “adding conditions might undercut the usefulness of the streamlined 

exemption”). It bears repeating, moreover, that the DOL has also stated that “the streamlined exemption 

would not expressly contain a ‘best interest’ standard.” Id.
September 16, 2016

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modern portfolio theory. Third, we consider the normal and customary way in which 

the law and economics of fiduciary investment come together in practice toward a 

highly individualized investment program that matches the investor’s purpose and risk 

tolerance with a diversified portfolio having an appropriate balance of risk and expected 

return. Fourth, we note in particular the central role of an “investment policy statement”

in sound fiduciary investment practice, and how the investment policy statement has

been emphasized by another federal regulator, the Office of the Comptroller of the 

Currency, in its examinations of banks conducting fiduciary activities.

Modern Portfolio Theory. The key insight of modern portfolio theory, for which 

Professor Harry M. Markowitz was awarded a Nobel Prize in 1990,61 is to differentiate 

between two kinds of investment risk in portfolio construction: market risk and 

idiosyncratic risk.

Market risk is inherent to participating in the market, reflecting the tendency to 

some extent for the market as a whole to move together. Market risk can be avoided 

only by avoiding the market, such as by holding cash or short-term government bonds.

Generally speaking, to obtain a greater expected return, an investor must take on 

additional market risk. Because an investor’s expected return increases with added 

exposure to market risk, such risk is sometimes called “compensated risk.”

Idiosyncratic risk, by contrast, is particular to a given investment, reflecting the 

fact that different investments react differently to certain changes in circumstances. A 

breakthrough in solar power, for example, would increase the value of an investment in 

an energy-dependent manufacturing company but would decrease the value of an 

investment in a coal company. By holding a diversified investment portfolio, that is, by

holding many different investments with imperfectly correlated idiosyncratic risks, an

investor can minimize or even eliminate overall idiosyncratic risk. It follows, therefore,

that each individual investment must be evaluated in light its contribution to overall 

portfolio risk and expected return.

Modern portfolio theory thus teaches that prudent portfolio construction 

requires: (1) assessing the individual investor’s risk tolerance and investment purposes; 

(2) choosing a portfolio with the level of market risk and expected return that is 

commensurate with that individual risk tolerance and purpose; and (3) avoiding or at 

least minimizing to the extent feasible wasteful idiosyncratic risk (i.e., uncompensated 

risk). Moreover, prudent portfolio management requires ongoing reassessment of the 

investor’s risk tolerance and investment purposes and periodic rebalancing of the 

overall portfolio for continuing alignment with the investor’s evolving risk tolerance and 

purposes.

The Law of Fiduciary Investment: The Prudent Investor Rule. The centerpiece of the 

law of fiduciary investment, both under ERISA and under trust law, is the “prudent 

 61 Harry M. Markowitz – Facts, Nobel Prize, http://www.nobelprize.org/nobel_prizes/economicsciences/laureates/1990/markowitz-facts.html (last visited Sep. 4, 2015).
September 16, 2016

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investor rule.”62 As canonically stated by the Restatement (Third) of Trusts (1992)63 and 

the Uniform Prudent Investor Act (1994), the prudent investor rule codifies the learning 

from modern portfolio theory about the distinction between market risk and 

idiosyncratic risk in two ways. First, “[a] trustee’s investment and management 

decisions respecting individual assets must be evaluated not in isolation but in the 

context of the trust portfolio as a whole and as a part of an overall investment strategy 

having risk and return objectives reasonably suited to the trust.”64 Second, a trustee 

must “diversify the investments of the trust unless the trustee reasonably determines 

that, because of special circumstances, the purposes of the trust are better served 

without diversifying.”65

As interpreted by the DOL and the United States Supreme Court, ERISA requires 

adherence to the prudent investor rule. Under a 1979 DOL regulation, ERISA § 404(a) 

requires an ERISA fiduciary to consider each investment “as part of the portfolio” and 

“with regard to diversification.”66 Moreover, in applying ERISA fiduciary law, including

to matters of fiduciary investment, the Supreme Court has “often noted that an ERISA 

fiduciary’s duty is ‘derived from the common law of trusts.’”67 Thus, in Tibble v. Edison 

International, decided in May 2015, the Court relied extensively on the Restatement 

(Third) of Trusts and the Uniform Prudent Investor Act, treating both as authoritative 

expositions of the principles applicable under ERISA to fiduciary investment matters.68

Accordingly, under both trust law and ERISA, the prudent investor rule requires 

a fiduciary to evaluate the investor’s risk tolerance and investment goals, choose a level 

of overall portfolio market risk and expected return that is commensurate with that risk 

tolerance and goals, and avoid wasteful idiosyncratic risk.69 At the outset of the

fiduciary relationship, the fiduciary has a “reasonable time” to “make and implement” a 

compliant investment program.70 What constitutes a reasonable time is context specific, 

 62 Uniform Prudent Management of Institutional Funds Act § 3 (Unif. Law Comm’n 2006), adopted in 

nearly every state, applies the prudent investor rule to charitable organizations in the management and 

investment of their endowment funds.

63 The 1992 Restatement provision on the prudent investor rule was superseded without material 

changes by Restatement (Third) of Trusts § 90 (Am. Law Inst. 2007). 

64 Unif. Prudent Inv’r Act § 2(b) (Unif. Law Comm’n 1994); see also Restatement (Third) of Trusts § 90(a).

65 Unif. Prudent Inv’r Act § 3; see also Restatement (Third) of Trusts § 90(b).

66 See 29 U.S.C. § 1104(a) (2013), as interpreted in 29 C.F.R. § 2550.404a-1(b) (2014).

67 Tibble v. Edison Int’l, 135 S. Ct. 1823, 1828 (2015); see also Comptroller of the Currency, Investment 

Management Services: Comptroller’s Handbook 116 (Aug. 2001), 

http://www.occ.gov/publications/publications-by-type/comptrollers-handbook/invmgt.pdf [hereinafter 

Comptroller’s Handbook] (“ERISA’s statutory and regulatory standards for prudent investing, 

diversification, and delegation of pension plan fiduciaries are also reflected in the Restatement (Third).”).

68 See Tibble, 135 S. Ct. at 1828.

69 Dukeminier and Sitkoff, supra note 26, at 635, surveys examples of “special circumstances” that could 

justify not diversifying and so bearing idiosyncratic risk.

70 Unif. Prudent Inv’r Act § 4; Restatement (Third) of Trusts § 92. Federal law likewise requires national 

banks, “[u]pon the acceptance of a fiduciary account for which [the bank] has investment discretion, ... [to] 

conduct a prompt review of all assets of the account to evaluate whether they are appropriate for the 

account.” 12 C.F.R. § 9.6(b) (2014).
September 16, 2016

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depending on factors such as the liquidity of the inception portfolio assets and the tax 

and other transaction costs of reallocation. 71

After the initial portfolio construction, a fiduciary remains under an “ongoing 

duty to monitor investments and to make portfolio adjustments if and as appropriate,”72

for example, by rebalancing the portfolio in light of actual investment performance and 

changes in the investor’s circumstances.73 The rule thus governs the fiduciary’s 

“continuing responsibility for oversight of the suitability of investments already made” 

as well as the fiduciary’s “decisions respecting new investments.”74

Application in Practice. Application of modern portfolio theory under the prudent 

investor rule is highly contextual. “[T]olerance for risk varies greatly with the financial 

and other circumstances of the investor, or in the case of a trust, with the purposes of the 

trust and the relevant circumstances of the beneficiaries.”75 Choosing the “appropriate 

degree of risk” for an investment portfolio involves “quite subjective judgments that are 

essentially unavoidable in the process of asset management.”76 Moreover, proper 

diversification requires an assessment of the portfolio as a whole, including the other

assets of the investor.77 Accordingly, assessing the proper amount of market risk and 

proper diversification strategies for a given investor requires a highly individualized 

consideration.

For example, time to retirement and an investor’s overall wealth are important 

factors in determining risk tolerance for a retirement account. But they are not the only 

relevant factors. Even investors who are similar in age and wealth are nonetheless likely 

to have differences in innate preferences for risk, health, and family circumstances that 

merit more or less risky portfolios. Unique financial circumstances, such as employment 

security and ownership of illiquid assets (e.g., homes or family businesses), also affect 

risk tolerance. 

Given the multiplicity of relevant factors, the law recognizes that “no objective, 

general legal standard can be set for a degree of risk that is or is not prudent.”78 A safe 

harbor that would validate an investment of any amount—whether 5, 10, 50, 75, or even 

100 percent—of an IRA or other investment account in any one fund determined to be 

“high quality” without regard for the individual retirement saver’s particular 

circumstances and tolerance for market risk is in irreconcilable tension with the settled 

 71 See Restatement (Third) of Trusts § 92 cmt. b.

72 Id. § 90 cmt. e(1).

73 See Tibble, 135 S. Ct. at 1828–29 (“In short, under trust law, a fiduciary normally has a continuing 

duty of some kind to monitor investments and remove imprudent ones.”).

74 Unif. Prudent Inv’r Act § 2 cmt.

75 Id.

76 Restatement (Third) of Trusts § 90 cmt. e(1).

77 See Dukeminier & Sitkoff, supra note 26, at 635 (“Diversification might not be necessary if the trust is 

but one piece of a larger program of wealth management such that the beneficiary’s financial interests are 

diversified overall. [Uniform Prudent Investor Act] §2(c)(6) ... lists ‘other resources of the beneficiaries’ as a 

relevant circumstance to be considered ‘in investing and managing trust assets.’”).

78 Restatement (Third) of Trusts § 90 cmt. e(1).
September 16, 2016

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law and well-accepted economics of fiduciary investment. Given the likely pull of the 

safe harbor, the resulting welfare losses from improper portfolio construction could be 

substantial.

Diversification to manage idiosyncratic risk must also be an individuated 

decision, even in the retirement context, because an IRA or other retirement account may 

not reflect the investor’s entire wealth. Consider an investment in a mutual fund that 

holds foreign stocks. Adding this investment could improve overall portfolio efficiency 

for an investor who held only domestic issues. But for an investor who was already 

heavily exposed to foreign stock markets in other accounts (retirement or otherwise), the 

same investment would reduce portfolio efficiency. Likewise, an investment in a mutual 

fund focused on small cap stocks could benefit an investor whose overall portfolio was 

overweighted in large cap stocks. But the very same investment could injure an investor 

whose overall portfolio already contained small cap stocks. Generally speaking, 

portfolio efficiency is improved by exposure to a variety of industries. However, an 

investor whose wholly owned small business was a technology company should 

probably avoid heavy investment in technology stocks given the likely correlation 

between the performance of those stocks and the investor’s own small business. 

The Investment Policy Statement. To ensure an orderly and rational process toward 

assessing the appropriate balance of risk and expected return in a fiduciary account, 

banks and other corporate fiduciaries typically require the preparation of “a written 

investment policy statement for each new trust account, reciting investment guidelines 

that reflect the purpose of the trust and the risk tolerance of the beneficiaries.”79 An 

investment policy statement will normally specify “the account’s risk tolerance” as well 

as its “investment goals and return requirements” in light of the particular 

circumstances of the account.80 An investment policy statement will also normally 

specify “asset allocation guidelines.”81 The normal and customary practice, which 

reflects the requirements of the prudent investor rule, is to apply portfolio theory in 

“deciding how to allocate portfolio assets among the major asset categories.”82 To the 

extent feasible, the “portfolio’s assets must be viewed together with the client’s other 

assets.”83 Consistent with the higher standard of care expected of a professional trustee, 

courts have rebuked bank trustees for failing in a timely manner to “establish an 

investment plan.”84 

 79 Dukeminier and Sitkoff, supra note 26, at 634.

80 Comptroller’s Handbook, supra note 67, at 106–07; see also fi360, Prudent Practices for Investment 

Advisors 47 (2013), http://www.fi360.com/main/pdf/handbook_advisor.pdf (An investment policy 

statement will normally specify “risk, return, and time horizon parameters” and will define “diversification 

and rebalancing guidelines.”).

81 Comptroller’s Handbook, supra note 67, at 107.

82 Id.

83 Id. at 106.

84 In re Estate of Janes, 681 N.E.2d 332, 338 (N.Y. 1997); see also In re Hunter, 955 N.Y.S.2d 163, 165 (App. 

Div. 2012). 
September 16, 2016

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Among other benefits, an investment policy statement facilitates “[r]ebalancing 

... to maintain proper diversification,” ensuring that the “portfolio avoids ‘allocation 

drift’ by not straying far from its targeted levels of risk and return.”85

Portfolio monitoring and revision is a continual and complicated process that 

requires extensive analysis and sound judgment. Asset categories may become 

over- or under-weighted in relation to the asset allocation guidelines because the 

returns on individual asset categories will vary over time. Portfolio re-balancing 

involves restoring the portfolio to appropriate percentage allocation ranges.86

An investment policy statement also provides a “‘paper trail’ in the event of an audit, 

litigation, or a dispute,”87 and it facilitates selection of “an appropriate performance 

benchmark” against which to compare the account’s performance.88

The Investment Management Handbook published by the Comptroller of the 

Currency to give guidance for bank examiners summarizes thus:

The creation of an appropriate investment policy document, or statement, is the 

culmination of analyzing the investment assignment, identifying investment 

objectives, determining asset allocation guidelines, and establishing performance 

measurement benchmarks. The lack of an investment policy statement, or the 

existence of a poorly developed one, is a weakness in portfolio management risk 

control.89

Crucially, each investment policy statement is highly individualized to the 

circumstances of the particular account, matching the investor’s purpose and risk 

tolerance with a diversified portfolio having an appropriate balance of risk and expected 

return in light of the circumstances. Moreover, because those circumstances will likely

evolve over time, the normal fiduciary practice is to undertake a periodic “investment 

policy review to analyze performance and reaffirm or change the investment policy, 

including asset allocation guidelines,” as warranted by changed circumstances.90

Conclusion

Motivated by concern over conflicts of interest among financial advisers to 

retirement savers, the DOL has proposed imposing fiduciary status and a “best interest” 

standard on such advisers. To ameliorate the resulting compliance costs, the DOL has 

also raised the possibility of a safe harbor for certain “high-quality low-fee investments.” 

However, the notion of a “high-quality” investment is in irreconcilable tension with the 

highly individualized assessment of risk and return that is required by modern portfolio 

theory, the well-accepted concept from financial economics that has been codified in the 

 85 fi360, supra note 80, at 48. 

86 Comptroller’s Handbook, supra note 67, at 111.

87 fi360, supra note 80, at 48.

88 Comptroller’s Handbook, supra note 67, at 108–10.

89 Id. at 110.

90 Id. at 112.
September 16, 2016

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“prudent investor rule” as the standard of care for fiduciary investment. This policy 

incoherence is worrisome because of the potential for the safe harbor to swallow the best 

interest rule. 

Under the prudent investor rule, a fiduciary must evaluate the investor’s risk 

tolerance and investment goals, choose a level of overall portfolio market risk and 

expected return that is commensurate with that risk tolerance and goals, and avoid 

wasteful diversifiable risk. The multiplicity of relevant considerations—including the 

investor’s risk preferences, age and health, family status and obligations, and other asset 

holdings and sources of support—necessarily requires an investor-specific analysis that 

cannot be captured in a safe harbor. What is a “high-quality” investment for one 

investor may entail too much risk for another, or even too much risk for the same 

investor at a later time. 

There is much to commend in the DOL’s effort to bring fiduciary investment 

principles to retirement saving. But the notion of a safe harbor for “high-quality low-fee” 

investments is misguided. A core principle in both the law and the economics of 

fiduciary investment is that no investment can be deemed categorically “high-quality” 

for all investors at all times. Thus, a safe harbor for certain “high-quality” investments is 

in irreconcilable tension with both the controlling law and well-accepted economics of 

fiduciary investment.